Success in the Market: New Rules or Old Brain?

Posted on 1 Mar 2014

One of the bennies of traveling is that one can get some unique local perspectives on larger current issues, which can be so rich when one just happens to be in such a culturally and educationally stimulating region like New England. So, as I was on a hotel treadmill listening to a local network interview a professor affiliated with the MIT Sloan School of Business’ Lab of Financial Engineering (that’s a mouthful, eh?) I heard a recommendation for today’s volatile economy that made me slow my pace down to 3.2 from 7.0. When I am working out, something pretty darn intriguing must get me to do that, by the way. What was it?

Well, it was actually something quite “reasonable” in how it sounded and anyone who knows my writing knows that that is the first sign for me to pause. This professor stated that there are now “three new rules” of navigating the unpredictable financial world post-economic meltdown. They are:

1. The market is not stable

2. Be aware of diversification deficit disorder

3. Though stocks may be good in the long term, they may kill ya in the short term

Now, I am no financier or philosopher but for these statements to be fully true as being important “new rules,” I would imagine the opposite of these phrases at one point would be the old news? That is, was there a time when markets were convincingly stable as a norm, diversification didn’t carry a need for a keen eye, and that the stock market didn’t really favor on average the non-emotionally reactive long run? Regardless, what hit me was the insistent nature of us all to make order out of chaos at all costs. Making meaning is a fundamental brain addiction with a pesky non-discerning quality to it that makes it tough to know when it is serving you and when it isn’t. To me this is the only rule one needs to remember. Don’t believe me? Check out this powerful research from Nobel Prize winning economist Daniel Kahneman.

Sometime ago he was called in for some neurofinance consulting with a Wall Street firm to do some research on some 25 anonymous investment advisors at this firm, combing over their investment outcomes over 8 consecutive years for signs of skill prediction. Their score here was really the main determinant for their year end bonus. While this “bonus” word rings now with associated words like greed and Occupy Wall Street, what Kahneman found, years before society became aware of the disproportionate bonuses being handed out, preceeds any alarm around greed—for too much of something is a quantity argument, usually not a validity argument. However, check out what he found. To assess some element of skill in these 25, he computed the correlation coefficients for each pair of years, totally 28 different coefficients. Though it is not big news to show here that skill is lower than people think, what he found was something way more mind-blowing: the average of the 28 coefficients was .01. In other words, zero. That is different than ‘weak” for sure. But the coolest part of the study is actually yet to come. When the data was shared with the firm’s leaders at dinner, that they rewarded luck as if it was skill, they didn’t seem alarmed and went on as business as usual. I believe this is not a greedy financier’s response yet evidence of a fundamental denial of truth in us all–whether we occupied Wall Street or not.

A zero coefficient and the brain’s denial of reality is all about the old, self-protective brain .There are no “new rules,” for that would imply some older form of predictive control around financial prediction got “updated”. Truth is, we never had ‘em. So my advice is to:

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